australia’s new forex regime

6 JOURNAL OF AUSTRALIAN TAXATION

AUSTRALIA’S NEW

FOREX REGIME

By Stephen Barkoczy*

Australia has recently adopted a revolutionary new codified regime for dealing with the taxation treatment of transactions that occur in foreign currency. The new “forex regime” largely replaces various ad hoc statutory and common law rules that had been developed over the years for dealing with foreign currency transactions. Leaving aside a limited number of exceptions, the new rules will generally be relevant whenever transactions take place in foreign currency and are, therefore, clearly of great importance to all tax practitioners and tax scholars.

The new forex regime comprises a set of rules for translating foreign currency into Australian currency and a set of rules for dealing with foreign currency exchange gains and losses. The new legislation introduces many new concepts and special terms, including the important notion of a “forex realisation event”.

This article provides a conceptual and theoretical framework for analysing the new legislation. It examines the operation of the key provisions in the statute and it provides a number of illustrations of how some of the main rules work in a practical context. It also touches on various underlying policy issues relating to the scheme.

1. INTRODUCTION Without doubt, one of the most significant tax reforms that

occurred in Australia last year was the introduction of the revolutionary new “forex regime”.1 The forex regime consists of two

* Associate Professor, Monash University and Consultant, Blake Dawson Waldron. 1 The forex regime was introduced pursuant to amendments contained in the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, which received assent on 17 December 2003 and became Act No 133 of 2003.

AUSTRALIA’S NEW FOREX REGIME

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separate, although inter-related, sets of provisions. The first set of provisions, located in Div 775 of the Income Tax Assessment Act 1997 (Cth) (“ITAA97”), deal with the tax treatment of foreign currency exchange gains and losses. The second set of provisions, located in Subdivs 960-C and 960-D of the ITAA97, contain rules for translating foreign currency into Australian currency. Together, these provisions represent a substantial body of new law and are of fundamental importance to the way in which transactions that occur in foreign currency are treated under the Australian income tax law.

1.1 The TOFA Reforms By way of background, the forex regime represents the second

stage in the federal government’s important taxation of financial arrangements (“TOFA”) reforms. These reforms were first mooted in the early 1990s. Since that time there has been an on-going consultative process between Treasury and the private sector with a view to developing an appropriate and consistent set of rules for taxing financial arrangements in Australia. Specific recommendations for reforming the way in which financial arrangements should be taxed were made in 1999 by the Review of Business Taxation in the “Ralph Report”.2 These recommendations were accepted “in principle” by the government shortly after the report was handed down3 and an agenda was then set for their implementation in four stages. The first stage of the TOFA reforms generally took effect from 1 July 2001, with the introduction of the controversial “debt and equity regime”.4 The second stage of the reforms, namely the new forex rules, generally operate in relation to transactions entered into from 1 July 2003. The third and fourth

2 Review of Business Taxation, A Tax System Redesigned (1999) 56-59 and 335-367. 3 Treasurer, Commonwealth of Australia, The New Business Tax System: Stage 2 Response, Press Release No 74 (November 1999) (Attachment N). 4 For a general discussion of this regime, see R Woellner, S Barkoczy, S Murphy and C Evans, Australian Taxation Law (2004) 1,134-1,146 and R Deutsch, M Friezer, I Fullerton, M Gibson, P Hanley and T Snape, Australian Tax Handbook (2004) 873-891.

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stages of the reforms are now proposed to operate from no earlier than 1 July 2004. The third stage relates to the taxation of commodity hedges while the fourth stage relates to various tax timing issues and synthetic arrangements.

1.2 Aims of This Article This article focuses exclusively on the new forex rules. These

rules are extremely technical in nature and introduce many new concepts, including eight different “forex realisation events”. As the forex regime is still new and many practitioners and scholars are therefore only just coming to grips with the way in which it operates, the main aim of this article is to provide readers with a general “roadmap” for navigating the complex web of provisions that make up the regime. In this regard, the article examines the operation of the key sections within the legislation (including the many important and lengthy tables that reside within these sections) and it provides a number of practical illustrations of how some of the main rules operate. The article also considers some of the policy aspects that underpin these rules and concludes with some broad observations about the regime.

The remainder of this article is divided into the following parts:

• Part 2 examines the new foreign currency translation rules, which consist of a “general translation rule” and a “functional currency translation rule”;

• Part 3 discusses the general nature of foreign currency exchange gains and losses and the circumstances in which they arise;

• Part 4 explains the way in which exchange gains and losses have been dealt with in the past under the income tax law;

• Part 5 outlines the general operation of the new foreign currency exchange gain and loss rules;

• Part 6 focuses on the eight different forex realisation events that arise under these rules; and


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• Part 7 contains the writer’s concluding comments on the new regime.

2. FOREIGN CURRENCY TRANSLATION RULES

A fundamental principle that underpins the Australian income tax system is that a taxpayer’s tax liability is required to be determined by reference to a constant unit of account. Not surprisingly, this unit of account is the Australian dollar (“A$”). Accordingly, for transactions that occur in foreign currencies, it is necessary to have mechanisms for translating relevant amounts into equivalent A$ amounts. One of the main roles of the new forex regime is to provide the necessary legislative framework for doing this.

Under the forex regime, the principal mechanism for translating foreign currency into A$ is contained in the “general translation rule” located in Subdiv 960-C ITAA97 (see 2.1). The general translation rule operates subject to special “functional currency rules” in Subdiv 960-D (see 2.2). These rules are superimposed upon the general provisions in the legislation and they work in conjunction with the specific foreign currency exchange gain and loss provisions located in Div 775 of the ITAA97 (see 5).

Subject to various exceptions and transitional arrangements, Subdivs 960-C and 960-D generally apply to transactions entered into from the beginning of the 2003/04 income year. However, where a taxpayer has a substituted accounting period and the first day of its 2003/04 income year is earlier than 1 July 2003, the relevant commencement date is the first day of its 2004/05 income year.5

The rules in Subdivs 960-C and 960-D replace a range of ad hoc currency translation rules that were previously scattered throughout the tax legislation.6 The”former rules”, however, generally continue to operate in those circumstances where the new rules do not apply. Consequently, these rules will continue to operate in relation to

5 ITAA97, ss 775-155 and 960-55(1). 6 See former ss 20, 102AAX and 391 of the Income Tax Assessment Act 1936 (Cth) (“ITAA36”) and s 103-20 of the ITAA97.

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transactions entered into before the commencement date of the forex regime. In addition, the “former rules” will also continue to be relevant to “ADIs” (eg banks) and “non-ADI financial institutions” (eg finance companies).7 This is because Subdiv 960-C and 960-D expressly do not apply to these entities by virtue of ss 960-55(3) and 960-60(5).

2.1 The General Translation Rule

The general translation rule is contained in s 960-50(1).8 This provision simply states that an “amount” in a foreign currency must be translated into Australian currency.9

2.1.1 Application to “Amounts”

Section 960-50(1) applies to “amounts” generally – in other words, it applies to all amounts that are relevant for any income tax calculation purpose.10 For example, it applies to an amount of “ordinary income”, an “expense”, an “obligation”, a “liability”, a “receipt”, a “payment”, “consideration” or a “value”.11 Furthermore, it applies irrespective of whether such an amount is on revenue, capital or other account.12 Amounts which are elements in the calculation of another amount are generally required to be translated prior to calculating the other amount.13

7 The concepts of an “ADI” and a “non-ADI financial institution” are defined in s 128A(1) of the ITAA36: ITAA97, s 995-1. 8 The general translation rule applies for both the purposes of the ITAA97 and the ITAA36. 9 In translating an amount into Australian currency, an entity must comply with the regulations which may, for instance, prescribe a particular translation method: ITAA97, s 960-50(8). 10 It does not, however, affect the operation of the provisions specified in s 960-50(10). 11 ITAA97, s 960-50(2). 12 ITAA97, s 960-50(3). 13 ITAA97, s 960-50(4). This rule does not, however, apply to another amount which is a “special accrual amount”. In other words, amounts taken into account in calculating a “special accrual amount” are not translated – it is only the result of the calculations (ie the special accrual amount) which is translated: ITAA97, s 960-50(5). A “special accrual amount” is an amount that is included in assessable income or allowed as a deduction under one of the following Divisions: Div 42A in Sch 2E of


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2.1.2 Specific Translation Rules The most important feature of the general translation rule is that

it contains a set of specific rules for determining the time at which particular amounts are translated into Australian currency. These rules are located in the table in s 960-50(6). The table sets out eleven specific translation rules, which operate subject to any modifications that may be made by the regulations.14 The eleven rules may be conveniently summarised as follows:

1. The amount of certain obligations to pay foreign currency that have ceased in circumstances where “forex realisation event 4” happens are translated at the exchange rate applicable at the”tax recognition time” under s 775-55(7) (see 6.4).

2. The cost of a depreciating asset is translated at the exchange rate applicable when the taxpayer began to hold the asset, or satisfied the liability to pay for it (whichever occurs first).

3. The value of trading stock on hand at the end of an income year which is valued at “cost” is translated at the exchange rate applicable at the time when the item became on hand.

4. The value of trading stock on hand at the end of an income year which is valued at “market selling value” or “replacement value” is translated at the exchange rate applicable at the end of the income year.

5. The amount of money, or the market value of property, relating to transactions or events under the CGT rules is

the ITAA36; Div 240 of the ITAA97; Div 16D of Pt III of the ITAA36; and Div 16E of Pt III of the ITAA36: ITAA97; s 995-1. 14 ITAA97, s 960-50(7). For example, the regulations might allow an “average” rather than a “spot” rate to be used for translation purposes.

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translated at the exchange rate applicable at the time of the transaction or event.

6. The amount of ordinary income is translated at the exchange rate applicable at the time of its derivation or receipt (whichever occurs first).

7. The amount of statutory income (other than an amount included in assessable income under the CGT rules in Div 102 of the ITAA97) is translated at the exchange rate applicable at the time of receipt or at the time when the requirement first arose to include it in assessable income (whichever occurs first).

8. The amount of a deduction (other than a deduction arising under the capital allowance rules in Div 40 of the ITAA97) is translated at the exchange rate applicable at the time of payment or the time the amount becomes deductible (whichever occurs first).

9. The amount of something that is relevant to quantifying a company’s expenditure on a film for the purposes of Div 376 of the ITAA97 is translated at the average exchange rate applicable to the period that starts at the earliest day on which principal photography or production of the animated images commenced and ends when the film is completed.

10. The amount required to be withheld from a payment under the PAYG provisions is translated at the exchange rate applicable at the time when the amount is required to be withheld.

11. The amount of any other payment or receipt is translated at the exchange rate applicable at the time of the receipt or payment.


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The following examples illustrate some of the above rules:

Examples

Item 2

X Co became the owner of a depreciating asset when it entered into a contract to purchase the asset from a United States company for US$1m on 1 July 2004 (when the exchange rate was A$1:US$0.50). X Co, however, only paid for the depreciating asset on 1 August 2004 (when the exchange rate was A$1:US$0.80).

Pursuant to the table in s 40-185(1)(b) of the ITAA97, the “cost” of the depreciating asset is determined by reference to the amount paid for the asset (US$1m). Applying the special translation rule in s960-50(6) (item 2) to that amount, the cost of the asset for the purposes of Div 40 would be A$2m (US$1m x 1.00/0.50), rather than A$1.25m (US$1m x 1.00/0.80). Accordingly, any capital allowance that X Co claims in respect of the depreciating asset would need to be based on a cost of A$2m.

Item 6

Y Co sells machinery to retailers in Europe and is ordinarily paid in Euro within three months of entering the contracts. On 1 June 2004, Y Co sold machinery to a German retailer for €6,000 (assume that at the time the exchange rate is A$1.00: €0.60). Y Co received payment on 1 September 2004 (assume that at the time the exchange rate is A$1.00: €0.90).

As Y Co accounts for its income on an earnings basis, it derives income of €6,000 in the 2003/2004 income year. As the income is derived prior to payment being received, Y Co is required to translate the foreign currency denominated income into Australian dollars at the exchange rate applicable at the time of derivation. Y Co’s income for the 2003/04 income year is therefore A$10,000 (€6,000 x $1.00/0.60).

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It is important to be aware that the above transactions will also result in “forex realisation events” occurring under Div 775. These events and their consequences are discussed in detail below (see 5 and 6).

2.2 The Functional Currency Rules

To reduce compliance costs associated with the general translation rule in Subdiv 960-C and to reflect commercial practice, Subdiv 960-D allows certain entities that keep their accounts solely or predominantly in a particular foreign currency to choose to work out their relevant tax calculations in that currency (the “functional currency”) and then to simply translate the net figure into Australian dollars.15 This overcomes the need to separately translate into A$ every single amount relevant to each transaction that is denominated in a foreign currency.

2.2.1 Entities That Can Choose to Use the Functional Currency Rules

The particular entities that are able to choose to use the functional currency rules and the particular amounts that these rules apply to are set out in the table in s 960-60(1). There are five situations covered by the table:

1. An Australian resident required to prepare financial reports under s 292 of the Corporations Act 2001 (eg a public company under that Act) can choose to work out so much of its taxable income or tax loss as is not covered by any of the other choices outlined below according to the “applicable functional currency”.

2. An Australian resident carrying on an activity or business through an overseas permanent establishment and a foreign resident carrying on an activity or business through an Australian permanent establishment can choose to work out the taxable income or tax loss derived

15 ITAA97, ss 960-56 and 960-59.


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from the activity or business carried on through the permanent establishment according to the “applicable functional currency”.

3. An offshore banking unit can work out its total “assessable OB income” and its total “allowable OB deductions” using the “applicable functional currency”.

4. An attributable taxpayer of a CFC can choose to work out the CFC’s total “attributable income” using the “applicable functional currency”.

5. A transferor trust can choose to work out its “attributable income” using the “applicable functional currency”.

2.2.2 Applicable Functional Currency

The “applicable functional currency” is the “sole or predominant” currency in which the “accounts” of the relevant entity, permanent establishment, offshore banking unit, CFC or transferor trust (as the case requires) are kept.16

2.2.3 Choosing to Use the Applicable Functional Currency

A choice to use the applicable functional currency must be made by the relevant entity in writing.17 The fourth column in the table in s 960-60(1) specifies when the choice has effect from. Broadly, a choice generally has effect from the commencement of the following income year (or statutory accounting period) unless the choice is a “backdated startup choice”18 in which case it generally has effect from the beginning of the income year (or statutory accounting period) in which the choice is made. A choice will continue to have effect until a withdrawal of the choice (which must also be made in writing) takes effect as determined in accordance with the table in s 960-90.19

16 ITAA97, s 960-70. 17 ITAA97, s 960-60(2). 18 Defined in s 960-65 of the ITAA97. 19 ITAA97, s 960-60(3) to (4).

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2.2.4 Translating Amounts Using an Applicable Functional Currency

The way in which amounts are translated using the applicable functional currency is set out in the table in s 960-80. Different translation rules apply depending on the entity involved and the particular kind of tax calculation undertaken (eg calculation of taxable income, tax losses, attributable income etc). In general terms, the translation rules require all relevant amounts that are not in the applicable functional currency (including A$ amounts) to be translated into the applicable functional currency. The relevant tax liability is then calculated in the applicable functional currency. This amount is then finally translated into A$.

2.2.5 Special Translation Rules for Amounts Attributable to Events That Straddle the Choice

Special two-stage translation rules, contained in s 960-85, operate where:

• as a result of a choice (the “current choice”) an entity is required to convert an amount to the applicable functional currency; and

• the amount is attributable to an event that happened, or a state of affairs that arose, at a time (the “event time”) before the choice took effect.

For example, these rules would operate to calculate the amount of a capital gain or capital loss in circumstances where an entity sells an asset after it has made a choice to use an applicable functional currency and the asset was acquired before that choice was made (eg when its cost was accounted for in A$ rather than foreign currency).

According to the tables in s 960-85, where no previous choice was in effect at the event time, the amount is first translated into A$ at the exchange rate applicable at the event time and secondly to the applicable functional currency at the exchange rate applicable when the current choice took effect. The same process operates where a previous choice has been made, except the previously applicable


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functional currency is substituted for Australian currency. The double translation is designed to ensure that any unrealised gain or loss that exists at the time of the choice does not escape taxation simply because the choice is made.20

3. NATURE OF FOREIGN CURRENCY EXCHANGE GAINS AND LOSSES

The new currency translation rules discussed above operate in conjunction with the new foreign currency exchange gain and loss rules discussed below (see 5). However, before turning to examine these rules, it is appropriate to first discuss the general nature of foreign currency exchange gains and losses (3.1 to 3.2) and to outline the various regimes that have dealt with such gains and losses in the past (see 4).

3.1 Circumstances in Which Foreign Currency Exchange Gains and Losses Arise

Foreign currency exchange gains and losses typically arise where taxpayers enter into contracts and the price is expressed in a foreign currency. If the exchange rate between the A$ and foreign currency fluctuates between the time the contract is entered into and the time the consideration is paid or received, the taxpayer will be required to pay, or will be entitled to receive, a different amount of A$ than the amount of A$ originally brought to account as assessable income or as a deduction under the currency translation rules. The difference in these amounts is the amount of the respective exchange gain or loss made by the taxpayer.

20 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, para 3.84.

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Example

Fred is a furniture exporter. On 1 June 2004 (when the exchange rate was A$1:US$0.80), Fred entered into a contract to supply furniture to a customer in the United States for US$100. Under the general translation rule (see 2.1), the US$100 is required to be translated into A$ at the time of derivation (ie on 1 June 2004). This results in Fred having to include A$125 (US$100 x 1.00/0.80) in his assessable income in the 2003/04 income year.

Fred only received payment of the US$100 on 30 August 2004 (when the exchange rate was A$1:US$0.50). The value of the US$100 receipt at such time is therefore A$200 (US$100 x 1.00/0.50).

In these circumstances, Fred has made a foreign currency exchange gain of A$75. The exchange gain has arisen because, while Fred only included an amount of A$125 in assessable income in the 2003/04 income year, he actually received an amount equivalent to A$200 in the 2004/05 income year. Accordingly, he is better off by A$75.

3.2 The Energy Resources Conversion Principle Under the common law, exchange gains and losses could only

arise where amounts in one currency were actually converted into another currency. This principle is vividly illustrated by the decision in FC of T v Energy Resources of Australia Ltd.21 This case concerned a taxpayer that had issued discounted euro notes in US dollars which it subsequently paid out in US dollars at face value. The High Court held that the taxpayer had not made any exchange gains or losses from the relevant transactions as only one currency

21 96 ATC 4536.


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was involved. In a joint judgment, Dawson, Toohey, Gaudron, McHugh and Kirby JJ stated:

This case has nothing to do with currency gains and losses, for the simple reason that the taxpayer dealt only in US dollars. The taxpayer made no currency gains or losses because it never converted any of the proceeds of the notes into Australian dollars. For Australian tax purposes, the only relevant conversion was the cost in Australian dollars of the loss made in US dollars when the taxpayer incurred its liability to pay the face value of the notes.22

Their Honours then went on to state: The taxpayer received US dollars, paid in US dollars, and did not convert the US dollars into Australian dollars. Where a taxpayer borrows money on capital account in US dollars and repays the loan in US dollars, it makes no revenue profit or loss from the borrowing even though the exchange rate may be different at each date.23

As a consequence of the introduction of the new currency translation rules, amounts relevant to tax calculations must now generally be translated into A$ irrespective of whether any actual conversion takes place. Accordingly, where these translation rules operate, exchange gains and losses can now arise even though no foreign currency has actually been converted into A$. In effect, this means that the outcome of Energy Resources would be different under the new rules.

It is clear that in drafting the forex rules, the legislature specifically sought to address the Energy Resources principle. This policy intent is clearly expressed in the Explanatory Memorandum to the Bill which introduced the forex regime where it is stated:

The forex provisions provide a statutory framework under which the gain or loss arising from these disparities is brought to account when it has been ‘realised’. This is the case even if the monetary elements of the transaction are not converted to A$.

22 Ibid 4540. 23 Ibid 4542.

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Without such a framework, foreign currency gains and losses arising out of ‘business’ transactions may fall outside the income tax net. This possibility is illustrated by FC of T v Energy Resources of Australia Ltd ...

The realisation rules, in conjunction with the core translation rule ... confirm the policy intent behind the tax treatment of foreign currency denominated transactions. These rules ensure that foreign currency gains and losses, whether on revenue or capital account, are brought to account, regardless of whether there is an actual conversion to A$. This will generally occur when the gains and losses are realised.24

4. PRE-FOREX REGIMES FOR DEALING WITH EXCHANGE GAINS AND LOSSES

Prior to the introduction of the forex regime, foreign currency exchange gains and losses were dealt with under a number of different tax regimes. For the purposes of this article, these regimes may be conveniently referred to as the “pre-forex regimes” and they are briefly outlined at 4.1 to 4.3 below. 4.1 General Taxation Regime

Initially, the only provisions that dealt with foreign currency exchange gains and losses under the Australian income tax law were the ordinary income and general deduction provisions contained in former s 25(1) and s 51(1) of the ITAA36 (now ss 6-5 and 8-1 of the ITAA97). To fall within these provisions it was necessary that the exchange gains and losses could be characterised as being of an income or revenue nature (as opposed to being of a capital nature).

More specifically, the cases dealing with the former ss 25(1) and 51(1) established that exchange gains are assessable and exchange losses are deductible in so far as they are referable to discharging or providing for liabilities on revenue account (eg the purchase or sale

24 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, paras 2.6-2.9.


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of trading stock): Texas Co (Australasia) Ltd v FC of T;25 International Nickel Australia Ltd v FC of T;26 Armco (Australia) Pty Ltd v FC of T;27 Caltex Ltd v FC of T, 28 Thiess Toyota Pty Ltd v FC of T,29 and AVCO Financial Services Ltd v FC of T.30

On the other hand, the cases also established that exchange gains and losses are capital in nature, and they were therefore not assessable or deductible under the ordinary income and general deduction provisions, where they are referable to expenditure incurred in strengthening a taxpayer’s business structure or capital base: Commercial & General Acceptance Ltd v FC of T,31 FC of T v Hunter Douglas Ltd.32

4.2 Division 3B

Division 3B of Pt III of the ITAA36 (s 82U to 82ZB) was introduced in the mid-1980s in order to bring certain exchange gains and losses that were of a capital nature (and which therefore did not fall within the ordinary income or general deduction provisions) within the tax system.

Division 3B applied to “currency exchange gains” and “currency exchange losses” that arose under an “eligible contract” (ie basically a contract entered into after 18 February 1986 or a “hedging contract” in respect of such a contract).33 The Division only applied to the extent to which the currency exchange gains and losses were of a “capital nature”34 and only to the extent to which:

25 (1940) 63 CLR 382. 26 (1977) 137 CLR 347; 77 ATC 4388. 27 (1948) 76 CLR 584. 28 (1960) 106 CLR 205. 29 78 ATC 4463 30 82 ATC 4246. 31 77ATC 4375. 32 83 ATC 4562. 33 ITAA36, s 82V(1). 34 ITAA36, s 82U(1).

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• the currency exchange losses, assuming they were not of a capital nature, would have been deductible to the taxpayer under s 8-1;35 and

• the currency exchange gains, assuming they were losses instead of gains and assuming they were not of a capital nature, would have been deductible to the taxpayer under s 8-1.36

In other words, the Division was focused on currency exchange gains and losses that were of an income producing or business character, but which did not fall within the ordinary income and general deduction provisions simply because they were of a capital nature. The Division did not apply to currency exchange gains and losses that were of a private character.

Where Div 3B applied, the following consequences flowed:

• the taxpayer was required to include in assessable income the amount of any currency exchange gain made during the year of income;37 and

• the taxpayer was (subject to certain limitations) entitled to a deduction for the amount of any currency exchange loss incurred during the year of income.38

4.3 CGT Regime Since foreign currency and rights in respect of foreign currency

constitute “CGT assets”,39 exchange gains and losses made under contracts entered into after 19 September 1985 also potentially fell within the CGT regime. In practice, however, the CGT regime did not usually bring such gains and losses to account, since the gains and losses were usually already brought to account under either the

35 ITAA36, s 82U(2). 36 ITAA36, s 82U(3). 37 ITAA36, s 82Y. 38 ITAA36, s 82Z. 39 ITAA97, s 108-5.


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general taxation rules or the special rules in Div 3B. The CGT regime ordinarily provided relief against double taxation or double benefit in these circumstances.40

5. GENERAL OPERATION OF DIVISION 775

The rules for dealing with currency exchange gains and losses under the new forex regime are contained in Div 775 of the ITAA97 (s 775-5 to s 775-285). The following discussion examines the general operation of this Division, which spans almost 50 pages of legislation. As mentioned previously, the rules in Div 775 work in conjunction with the foreign currency translation rules discussed above.

5.1 Application

The forex regime generally applies to gains and losses on rights and obligations acquired or assumed under transactions entered into from the beginning of the 2003/04 income year. However, if the taxpayer has a substituted accounting period and the first day of its 2003/04 income year is earlier than 1 July 2003, the relevant commencement date is the first day of its 2004/05 income year.41

While the forex regime generally applies prospectively (ie to gains and losses on transactions entered into from the commencement date), a transitional rule allows taxpayers to elect to have the forex rules apply to gains and losses made on transactions entered into before the commencement date, but realised after that date.42There is also a special rule which provides that the forex rules apply to rights and obligations relating to loans entered into before the commencement date that are extended after that date.43

40 See, eg, ss 118-20 and 118-55 of the ITAA97. 41 ITAA97, s 775-155. 42 ITAA97, ss 775-150 and 775-165. For most taxpayers this election had to be made by 16 January 2004. See further N Ward, (2004) 1 Tax Week 1. 43 ITAA97, s 775-165.

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The forex regime has been designed to largely replace the former regimes dealing with exchange gains and losses. To the extent that any gains or losses fall within the forex regime, they are not also assessable or deductible under other provisions in the legislation (eg they do not fall within the ordinary income or general deduction provisions).44 This ensures that the forex regime operates as the exclusive regime for dealing with exchange gains and losses and that no double taxation or double benefit arises.

In addition, Div 3B of Pt III of the ITAA36 has been repealed from the commencement of the forex regime. A special transitional rule, however, maintains the operation of the Division (ie it is treated as if it had not been repealed) in relation to eligible contracts entered into before the commencement date.45 The operation of the Division is also expressly maintained in relation to ADIs (eg banks) and non-ADI financial institutions (eg finance companies), which are expressly excluded from the forex regime pursuant to s 775-170.46

Accordingly, while the forex regime now contains the principal rules for dealing with exchange gains and losses, it does not apply in all cases. In those circumstances where the forex regime does not apply, the pre-forex regimes (see 4) will generally continue to operate.

5.2 Aim of Div 775 Division 775 has been designed as a comprehensive taxation

framework for dealing with currency exchange gains and losses. The principal aim of the Division is to include “forex realisation gains” in assessable income and to allow deductions for “forex realisation losses”.

44 ITAA97, ss 775-15(4) and 775-30(4). 45 New Business Tax System (Taxation of Financial Arrangements) Act (No 1) 2003, s 77(1)(a). 46 New Business Tax System (Taxation of Financial Arrangements) Act (No 1) 2003, s 77(1)(b).


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5.3 Forex Realisation Events

Forex realisation gains and forex realisation losses arise as a result of the happening of “forex realisation events”. There are five main kinds of forex realisation events:

• forex realisation event 1 (“FRE 1”) happens when an entity disposes of foreign currency or a right to foreign currency to another entity (see 6.1);

• forex realisation event 2 (“FRE 2”) happens when an entity ceases to have a right to receive foreign currency (see 6.2);

• forex realisation event 3 (“FRE 3”) happens when an entity ceases to have an obligation to receive foreign currency (see 6.3);

• forex realisation event 4 (“FRE 4”) happens when an entity ceases to have an obligation to pay foreign currency (see 6.4); and

• forex realisation event 5 (“FRE 5”) happens when an entity ceases to have a right to pay foreign currency (see 6.5).

In addition, there are three further kinds of forex realisation events which operate where certain choices have been made. Forex realisation event 6 (“FRE 6”) and forex realisation event 7 (“FRE 7”) relate to roll-over relief claimed in respect of a facility agreement under Subdiv 775-C (see 6.9). Forex realisation event 8 (“FRE 8”) relates to the retranslation election in respect of a qualifying forex account under Subdiv 775-E (see 6.11).

5.4 The Basic Rules and Their Exceptions

Underpinning the operation of Div 775 are two basic rules:

• The “basic rule” in s 775-15(1) provides that a taxpayer is required to include in assessable income, a “forex realisation gain” from a “forex realisation event” that happens during the year.

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• The “basic rule” in s 775-30(1) provides that a taxpayer can deduct a “forex realisation loss” from a “forex realisation event” that happens during the year.

These basic rules operate subject to the following exceptions:

• Private or domestic exceptions. Forex realisation gains that are of a private or domestic nature are not assessable income unless they would be taken into account under the CGT provisions47 and they relate to: (i) the disposal of a CGT asset that is foreign currency or a right to foreign currency; (ii) the discharge of a right acquired in return for the realisation of another kind of CGT asset; or (iii) the discharge of an obligation incurred to acquire a CGT asset.48 Furthermore, forex realisation losses that are of a private or domestic nature are not deductible unless they relate to: (i) the discharge of a right acquired in return for realising another kind of CGT asset; or (ii) the discharge of an obligation incurred to acquire a CGT asset.49

• Exempt income and non-assessable non-exempt income exceptions. Forex realisation gains are, respectively, exempt income or non-assessable non-exempt income to the extent that the gains, if they had been losses, would have been made in gaining or producing exempt income or non-assessable non-exempt income.50 Also, forex realisation losses are not deductible to the extent that they are made as a result of: (i) FRE 1, FRE 2 or FRE 5 and are made in gaining or producing exempt income; or (ii) FRE 3, FRE 4 or FRE 6 and are made in gaining or producing exempt income or non-assessable non-exempt income

47 In other words, they would not be disregarded under any CGT exemptions such as the personal use asset exemption in s 118-10 of the ITAA97. 48 ITAA97, s 775-15(2). 49 ITAA97, s 775-30(2). 50 ITAA97, ss 775-20 and 775-25.


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provided the relevant obligation does not give rise to a deduction.51

• Short-term forex realisation exceptions. Forex realisation gains are not assessable to the extent that they relate to “short-term forex realisation gains” as outlined in s 775-70 (see 6.8).52 Likewise, forex realisation losses are not deductible to the extent that they relate to “short-term forex realisation losses” as outlined in s 775-75 (see 6.8).53

To prevent double taxation of gains, s 775-15(4) provides that to the extent that a forex realisation gain would otherwise be included in assessable income under another provision (eg under s 6-5), the gain is only included in assessable income under s 775-15. Similarly, to prevent double deductions for losses, s 775-30(4) provides that to the extent that a forex realisation loss would otherwise be deductible under another provision (eg under s 8-1), the loss is only deductible under s 775-30.

5.5 Calculating the Amount of a Forex Realisation Gain or Forex Realisation Loss

The way in which a forex realisation gain or a forex realisation loss is calculated depends on the kind of forex realisation event involved. In general, the amount of the gain or loss is calculated according to one of the following two broad methods:

• Currency exchange rate effect method. Under the first method, the gain or loss is based on the “currency exchange rate effect” as defined in s 775-105. Essentially, the “currency exchange rate effect” is the amount of the relevant currency fluctuation that has arisen under the event. This is usually the difference between the A$ cost of the foreign currency or right and the A$ proceeds for its

51 ITAA97, s 775-35. 52 ITAA97, s 775-15(3). 53 ITAA97, s 775-30(3).

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disposal. It can also be the difference between an agreed currency exchange rate for a future date or time and the actual currency exchange rate at the date or time.

• Alternative method. Under the second method, the gain or loss is based on the difference between the A$ cost of a right or obligation to receive or pay foreign currency at its “tax recognition time” and the A$ amount paid or received in satisfaction of that right or obligation.54 The “tax recognition time” is generally the time that the right or obligation is first recognised under the tax system (eg as income, a deduction, a cost or disposal proceeds etc).

In undertaking the above calculations, the new currency translation rules discussed above (see 2) are used to convert foreign currency amounts into A$.

6. FOREX REALISATION EVENTS AND OTHER SPECIAL RULES

As mentioned above (see 5.3), forex realisation gains and losses arise as a result of the happening of one of the eight different kinds of “forex realisation events”. These events are, therefore, the trigger for the operation of the currency exchange gain and loss provisions in much the same way as “CGT events” are the trigger for the operation of the capital gain and loss provisions.55 The following discussion (see 6.1 to 6.11) examines each of the specific forex

54 A constructive receipts and payments rule ensures that if an entity (the “payer”) did not actually pay an amount to another entity (the “recipient”), but the amount was applied or dealt with in any way on the recipient’s behalf as the recipient directs, then the payer is taken to have paid and the recipient is taken to have received the relevant amount as soon as it is applied or dealt with: ITAA97, s 775-110. 55 The forex regime and the CGT regime also overlap in places. See, for instance, the overlap between FRE 1 and CGT event A1 (see 6.1). Note also the interaction between the short-term forex realisation gain and loss rules and CGT event K10 and CGT event K11 (see 6.8.2).


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realisation events as well as various special rules that apply in relation to these events.

6.1 Forex Realisation Event 1 (Disposal of Foreign Currency): s 775-40

FRE 1 arises where “CGT event A1” happens in relation to the disposal of foreign currency, or a right, or part of a right, to receive foreign currency.56 The time of the forex realisation event is when the foreign currency, or right, or part of the right, to foreign currency is disposed of.57

CGT event A1 happens where there is a change in the beneficial ownership of a CGT asset from one entity to another.58 Thus, FRE 1 arises when there has been a change in the beneficial ownership of foreign currency or a right, or part of a right, to receive foreign currency from one entity to another entity.59 For example, FRE 1 will occur where a taxpayer sells foreign currency, or assigns its rights under an option to acquire foreign currency, to another entity. It is particularly important to realise that every time foreign currency is paid to another entity (eg as consideration under a contract), the foreign currency will be disposed of and it will therefore be necessary to consider the application of FRE 1. This forex realisation event is therefore extremely common.

56 ITAA97, s 775-40(1). 57 ITAA97, s 775-40(3). 58 ITAA97, s 104-10. Note that in applying FRE 1, certain modifications are made to the way in which the CGT provisions operate. In particular, there is a special rule which provides that if the capital proceeds from the event are more or less than the market value of the foreign currency, right, or part of the right, the capital proceeds are taken to be the market value: ITAA97, s 775-40(9). Special rules also require certain CGT provisions that would otherwise be relevant for the purposes of calculating capital gains and losses to be disregarded. The provisions that must be disregarded are: s 118-20 (which reduces a capital gain by certain amounts that are otherwise assessable), Div 114 (which relates to indexation) and s 118-55 (which disregards certain foreign currency hedging gains and losses): ITAA97 s 775-40(5), (7) and (8). 59 ITAA97, s 775-40(2).

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The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 1 are as follows:

• Forex realisation gain. An entity makes a forex realisation gain under FRE 1 if it makes a capital gain from CGT event A1 and some or all of that capital gain is attributable to a currency exchange rate effect. The amount of the forex realisation gain is that part of the capital gain (if any) which is attributable to a currency exchange rate effect.60

• Forex realisation loss. An entity makes a forex realisation loss under FRE 1 if it makes a capital loss from CGT event A1 and some or all of that capital loss is attributable to a currency exchange rate effect. The amount of the forex realisation loss is that part of the capital loss (if any) which is attributable to the currency exchange rate effect.61

The following example illustrates the operation of FRE 1.

Example

In January 2004 (when the exchange rate was A$1:US$0.80), X Co acquired US$10m. In February 2004 (when the exchange rate was A$1:US$0.50), X Co used the US$10m to purchase shares listed on the NASDAQ stock exchange.

The US$10m foreign currency is a CGT asset which has a cost base of A$12.5m (US$10m x 1.00/0.80). CGT event A1 happens when X Co disposed of the foreign currency to buy the shares. The capital proceeds from the disposal is A$20m (US$10m x 1.00/ 0.50), being the market value of the shares.

Accordingly, pursuant to FRE 1, X Co has made a forex realisation gain of A$7.5m (A$20m – A$12.5m)

60 ITAA97, s 775-40(4). 61 ITAA97, s 775-40(6).


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6.2 Forex Realisation Event 2 (Ceasing to Have a Right to Receive Foreign Currency): s 775-45

FRE 2 happens if the following three conditions specified in s 775-45(1) are fulfilled:

(a) an entity ceases to have a right, or part of a right, to receive foreign currency;62

(b) the right, or part of the right, is:

• a right, or part of a right, to receive, or that represents, ordinary income or statutory income (other than statutory income assessable under Div 775 or the CGT rules in Div 102);

• a right, or part of a right, created or acquired in return for ceasing to hold a depreciating asset;

• a right, or part of a right, created or acquired in return for paying or agreeing to pay Australian or foreign currency; or

• a right, or part of a right, created in return for a “realisation event”63 happening in relation to a CGT asset not covered by the previous classes of right; and

(c) the entity did not cease to have the right, or part of the right because it was disposed of.

The time of the forex realisation event is when the entity ceases to have the right or part of the right to receive the foreign currency.64

FRE 2 commonly occurs when a right to receive foreign currency is satisfied by the actual receipt of the foreign currency. It is

62 A right to receive foreign currency may be contingent and it includes a right to receive an amount of A$ that is calculated by reference to an exchange rate: ITAA97, s 775-135(1) and (2). 63 Defined in Div 977 of the ITAA97. 64 ITAA97, 775-45(2).

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important to note that FRE 2 does not occur where the right to receive foreign currency is disposed of to another entity as, in such case, “FRE 1” would apply.


• Forex realisation gain. An entity makes a forex realisation gain under FRE 2 if the amount the entity receives in respect of the event exceeds the “forex cost base”65 of the right, or part of the right (worked out at the “tax recognition time”)66 and some or all of that excess is attributable to a currency exchange rate effect. The amount of the forex realisation gain is that part of the excess (if any) which is attributable to the currency exchange rate effect.67

• Forex realisation loss. An entity makes a forex realisation loss under FRE 2 if the amount received for the right, or part of the right, falls short of the “forex cost base” of the right, or part of the right (worked out at the “tax recognition time”) and some or all of the shortfall is attributable to a currency exchange rate effect. The amount of the forex realisation loss is so much of the shortfall as is attributable to the currency exchange rate effect.68 An entity also makes a forex realisation loss if the event happens because an option to buy foreign currency expires without having been exercised, or is cancelled, released or

65 The “forex cost base” of a right, or part of a right, to receive foreign currency is, broadly, the sum of the money paid and the market value of any non-cash benefit provided in respect of acquiring the right or part of the right reduced by any amounts that are deductible outside Div 775: ITAA97, s 775-85. 66 For the purposes of s 775-45, the “tax recognition time” is worked out according to the table in s 775-45(7). Essentially, it is the time that the right, or part of the right, is recognised under the tax law (eg where the right is ordinary income, it is the time when the ordinary income is derived). 67 ITAA97, s 775-45(3). 68 ITAA97, s 775-45(4).


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abandoned and the entity was capable of exercising the option immediately before the event. The amount of the forex realisation loss is the amount paid in return for the grant or acquisition of the option.69

The following example illustrates the operation of FRE 2: Example

Betty is a software exporter. On 1 April 2004 (when the exchange rate was A$1:US$0.80), she entered into a contract to supply products to a customer in the United States for US$1,000.

As a consequence of entering into the contract, Betty has a right to receive foreign currency (ie US$1,000). The forex cost base of the right is determined at the “tax recognition time”, which is when the income is derived (ie 1 April 2004). The forex cost base of the right in A$ is therefore A$1,250 (US$1,000 x 1.00/0.80). Betty is required to include this amount in her assessable income for the 2003/04 income year under s 6-5.

Betty’s customer pays Betty the US$1,000 on 1 October 2004 (when the exchange rate was A$1:US$0.50). As a consequence of the payment, Betty ceases to have the right to receive the foreign currency as the debt is satisfied. This results in FRE 2 happening on 1 October 2004. The A$ amount that Betty receives in respect of the event is A$2,000 (US$1,000 x 1.00/ 0.50).

As the amount Betty receives in respect of the event (A$2,000) is greater than the forex cost base of the right (A$1,250), Betty has made a forex realisation gain of $750. She must include this in her assessable income for the 2004/05 income year pursuant to s 775-15.

69 ITAA97, s 775-45(5).

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6.3 Forex Realisation Event 3 (Ceasing to Have an Obligation to Receive Foreign Currency): s 775-50

FRE 3 happens under s 775-50(1) if:

(a) an entity ceases to have an obligation, or part of an obligation, to receive foreign currency;70 and

(b) the obligation, or part of the obligation, was incurred in return for the creation of a right to pay foreign currency71 or Australian currency.72

The time of the forex realisation event is when the entity ceases to have the obligation or part of the obligation.73

FRE 3 commonly occurs where a taxpayer has granted another entity a “put option” that requires the taxpayer to acquire foreign currency and either: (i) the option is exercised or expires, or (ii) the taxpayer is released from its obligations under the option.


• Forex realisation gain. An entity makes a forex realisation gain under FRE 3 if the amount received in respect of the event exceeds the “net costs of assuming the obligation”74 or the part of the obligation (worked out at the “tax recognition time”)75 and some or all of the excess is

70 An obligation to receive foreign currency may be contingent and includes an obligation to receive an amount of A$ that is calculated by reference to an exchange rate: ITAA97, s 775-140(3) and (4). 71 A right to pay foreign currency may be contingent and includes a right to pay an amount of A$ that is calculated by reference to an exchange rate: ITAA97, s 775-135(3) and (4). 72 A right to pay Australian currency may be contingent: ITAA97, s 775-50(8). 73 ITAA97, s 775-50(2). 74 The net costs of assuming an obligation, or part of an obligation, to receive foreign currency is worked out in accordance with s 775-100. 75 For the purposes of s 775-50, the “tax recognition time” is the time when the entity received an amount in respect of the event happening.


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attributable to a currency exchange rate effect. The amount of the forex realisation gain is so much of the excess as is attributable to a currency rate exchange effect.76 An entity also makes a forex realisation gain under FRE 3 if the event happens because an option to sell foreign currency expires without having been exercised, or is cancelled, released or abandoned; and, if the option had been exercised before the event, the entity would have been obliged to buy the foreign currency. The amount of the forex realisation gain is the amount the entity received in return for granting or assuming obligations under the option.77

• Forex realisation loss. An entity makes a forex realisation loss under FRE 3 if the amount the entity receives in respect of the event falls short of the net costs of assuming the obligation or the part of the obligation (worked out at the “tax recognition time”) and some or all of the shortfall is attributable to the currency exchange rate effect. The amount of the forex realisation loss is so much of the shortfall as is attributable to the currency exchange rate effect.78

6.4 Forex Realisation Event 4 (Ceasing to Have an Obligation to Pay Foreign Currency): s 775-55

FRE 4 happens if an entity ceases to have an obligation, or part of an obligation, to pay foreign currency and the obligation, or part of the obligation, is one which falls within the list in s 775-55(1)(b).79 This list covers, a broad range of obligations. For instance, it covers: obligations that are deductible expenses; obligations that are elements in the calculation of certain net amounts included in assessable income or deductions; and obligations thatform elements of the cost base of a CGT asset. It also covers

76 ITAA97, s 775-50(3). 77 ITAA97, s 775-50(4). 78 ITAA97, s 775-50(5). 79 Note that FRE 4 operates subject to the roll-over relief available under Subdiv 775-C in relation to “facility agreements” (see 6.9).

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obligations incurred in return for receiving Australian or foreign currency, or the right to receive such currency. The time of the forex realisation event is when the entity ceases to have the obligation or part of the obligation.80

FRE 4 commonly occurs when a taxpayer actually makes a payment of foreign currency. For example, FRE 4 would occur when a taxpayer pays an amount of foreign currency in relation to a deductible expense that it has incurred or where it pays an amount of foreign currency to acquire a CGT asset.


• Forex realisation gain. An entity makes a forex realisation gain under FRE 4 if the amount paid in respect of the event falls short of the “proceeds of assuming the obligation”81 or part of the obligation (worked out at the “tax recognition time”)82 and some or all of the shortfall is attributable to a “currency rate effect”. The amount of the forex realisation gain is so much of the shortfall as is attributable to a currency rate effect.83 An entity also makes a forex realisation gain under FRE 4 if the event happens because an option to sell foreign currency expires without being exercised, or is cancelled, released or abandoned and, if the option had been exercised immediately before the event, the entity would have been obliged to sell the foreign

80 ITAA97, s 775-55(2). 81 The proceeds of assuming an obligation to pay foreign currency is the sum of the money received and the market value of non-cash benefits acquired in return for incurring the obligation, reduced by any amounts that are deductible outside Div 775: ITAA97, s 775-95. 82 For the purposes of s 775-55, the “tax recognition time” is worked out according to the table in s 775-55(7). Essentially, it is the time that the obligation, or part of the obligation, is recognised under the tax law (eg where the obligation is a deductible expense, it is the time when the expense becomes deductible). 83 ITAA97, s 775-55(3).


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currency. The amount of the forex realisation gain is the amount received in return for granting or assuming obligations under the option.84

• Forex realisation loss. An entity makes a forex realisation loss under FRE 4 if the amount paid in respect of the event exceeds the proceeds of assuming the obligation, or part of the obligation, (worked out at the “tax recognition time”) and some or all of the excess is attributable to a “currency rate effect”. The amount of the forex realisation loss is so much of the excess as is attributable to a currency rate effect.85 The following example illustrates the operation of FRE 4:

Example

Pamela operates a beauty parlour and imports make-up from overseas which she sells in the ordinary course of her business. On 1 April 2004 (when the exchange rate was A$1:US$0.80), she entered into a contract to purchase make-up from a supplier in the United States for $US1,000.

As a consequence of entering into the contract, Pamela has an obligation to pay foreign currency (ie US$1,000). The proceeds of assuming the obligation is determined at the “tax recognition time”, which is when the outgoing became deductible (ie 1 April 2004). The proceeds of assuming the obligation in A$ is therefore A$1,250 (US$1,000 x 1.00/0.80). Pamela is entitled to a deduction for this amount in the 2003/04 income year under s 8-1.

Pamela pays her supplier US$1,000 on 1 October 2004 (when the exchange rate was A$1:US$0.50). As a consequence of the payment, Pamela ceases to have an obligation to pay the foreign currency as she has satisfied the debt. This results in FRE 4 happening on

84 ITAA97, s 775-55(4). 85 ITAA97, s 775-55(5).

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1 October 2004. The A$ amount that Pamela pays in respect of the event is A$2,000 (US$1,000 x 1.00/0.50).

As the amount Pamela pays in respect of the event (A$2,000) exceeds the proceeds of assuming the obligation (A$1,250), Pamela has made a forex realisation loss of $750. She is entitled to a deduction for this amount in the 2004/05 income year pursuant to s 775-30.

6.5 Forex Realisation Event 5 (Ceasing to Have a Right to Pay Foreign Currency): s 775-60

FRE 5 happens if an entity ceases to have a right, or part of a right, to pay foreign currency86 and the right, or part of the right, is created or acquired in return for the assumption of an obligation to pay foreign currency or Australian currency.87 The time of the forex realisation event is when the taxpayer ceases to have the right or part of the right.88

FRE 5 commonly occurs where a taxpayer has a call option requiring another entity to acquire the taxpayer’s foreign currency and either: (i) the option is exercised or expires, or (ii) the taxpayer releases the other entity from the terms of the option.


• Forex realisation gain. An entity makes a forex realisation gain under FRE 5 if the amount the entity pays in respect of the event falls short of the “forex entitlement base”89 of the

86 A right to pay foreign currency may be contingent and includes a right to pay an amount of A$ that is calculated by reference to an exchange rate: ITAA97, s 775-135(3) and (4). 87 ITAA97, s 775-60(1). 88 ITAA97, s 775-60(2). 89 The forex entitlement base of a right, or part of a right, to pay foreign currency is worked out under s 775-90.


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right or part of the right (worked out at the “tax recognition time”)90 and some or all of the shortfall is attributable to a “currency rate effect”. The amount of the forex realisation gain is so much of the shortfall as is attributable to the currency rate effect.91

• Forex realisation loss. An entity makes a forex realisation loss under FRE 5 if the amount the entity pays in respect of the event exceeds the forex entitlement base of the right or part of the right (worked out at the tax recognition time) and some or all of the excess is attributable to a currency rate effect. The amount of the forex realisation loss is so much of the excess as is attributable to the currency exchange rate effect.92 An entity also makes a forex realisation loss under FRE 5 if the event happens because an option to sell foreign currency expires without having been exercised, or is cancelled released or abandoned and the entity was capable of exercising the option immediately before the event happened. The amount of the forex realisation loss is the amount the entity paid in return for the grant or acquisition of the option.93

6.6 Multiple Forex Realisation Events

There are cases in which a particular transaction might give rise to more than one forex realisation event. For example, a transaction involving the future sale of one foreign currency in exchange for another foreign currency will involve both a right or obligation to receive foreign currency and a right or obligation to pay foreign currency. In order to prevent the duplication of forex realisation gains and losses in these cases, s 775-65 contains a table that specifies which forex realisation events are to be ignored. The aim of

90 For the purposes of s 775-60, the “tax recognition time” is the time when an amount in respect of the event is paid: ITAA97, s 775-60(7). 91 ITAA97, s 775-60(3). 92 ITAA97, s 775-60(4). 93 ITAA97, s 775-60(5).

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the provision is to ensure that a particular taxpayer can only make one forex realisation gain or loss from a single transaction. This principle is illustrated in the following example.

Example

Trader holds an option to buy US$ in exchange for Euro at a particular price. Trader therefore has a right to buy foreign currency ($US) and an obligation to pay foreign currency (Euro) which is contingent on Trader exercising the option.

If Trader sells its option, FRE 1 (disposal of right to foreign currency) and FRE 4 (ceasing of obligation to pay foreign currency) would arise. In this situation the table in s 775-65 ignores FRE 4 (ie the forex realisation gain or loss will be calculated under FRE 1).

If Trader, instead, exercised its option, FRE 2 (ceasing of right to receive foreign currency) and FRE 4 (ceasing of obligation to pay foreign currency) would arise. In this situation the table in s 775-65 ignores FRE 4 (ie the forex realisation gain or loss will be calculated under FRE 2).

6.7 Application of Forex Realisation Events to Currency and Fungible Rights and Obligations

Taking into account that currency is “fungible” in nature (ie a unit of currency is identical to any other unit of the same currency), this can pose difficulties in applying the forex rules to pools of currency. For example, part of the foreign currency held in a bank account may be used to make a payment to another entity. This constitutes FRE 1 as the foreign currency is disposed of. However, ordinarily, it may be difficult to work out the relevant forex realisation gain or loss from such a transaction as it may be difficult to determine the A$ cost of the foreign currency since amounts may


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have been deposited into the account at different times when different exchange rates applied.

To address this kind of problem, s 775-145(1) provides that FRE 1, FRE 2, or FRE 4 operate on a “first in first out” (“FIFO”) basis in relation to foreign currency or a fungible right or fungible obligation to pay foreign currency.94 The following example illustrates how this rule operates.

Example

X Co is an exporter that operates a US$ bank account. After opening the account, it receives the following payments from its customers:

On 1 July 2004 (when the exchange rate was A$1:US$0.50) – a payment of US$20,000. This amount is equivalent to A$40,000 (US$20,000 x 1.00/0/50).

On 15 July 2004 (when the exchange rate was A$1:US$0.80) – a payment of US$10,000. This amount is equivalent to A$12,500 (US$10,000. x 1.00/0.80).

On 20 July 2004 (when the exchange rate was A$1:US$0.60), X Co makes a payment from its bank account to one of its suppliers of US$25,000. This amount is equivalent to A$41,667 (US$25,000 x 1.00/0.60).

This payment results in FRE 1 happening to US$20,000 received on 1 July and US$5000 received on 15 July. The cost base of the foreign currency is A$46,250 (A$40,000 + A$6,250).

X Co therefore makes a forex realisation loss on 20 July of A$4,583 (A$46,250 - A$41,667).

94 Note that, in spite of the FIFO principle, the regulations may prescribe that the relevant forex realisation events are to apply on a “weighted average basis”: ITAA97, s 775-145(2).

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6.8 Short-term Forex Realisation Gains and Losses

As mentioned above (see 6), the basic rules that require forex realisation gains to be included in assessable income (s 775-15) and allow deductions for forex realisation losses (s 775-30) operate subject to special rules relating to “short-term forex realisation gains” (s 775-70) and “short-term forex realisation losses” (s 775-75).

The “short-term rules” apply to forex realisation gains and losses arising as a result of FRE 2 and FRE 4. More specifically, they apply to gains and losses on:

• a right to receive foreign currency arising from disposing a CGT asset;

• an obligation to pay foreign currency for acquiring a CGT asset; and

• an obligation to pay foreign currency for a depreciating asset.

The short-term rules operate in the first two cases if a CGT asset is acquired or disposed of and the time between the acquisition or disposal of the asset and the date for payment or receipt of the foreign currency is not more than 12 months. The short-term rules operate in the third case if the time between a depreciating asset beginning to be held and the date for payment of the foreign currency is not more than 12 months before or 12 months after the date the asset began to be held.

Where the short-term rules operate, any forex realisation gains and losses are not brought to account as assessable income or deductions under the basic rules. Instead, the gains and losses are integrated into the tax treatment of the underlying assets (see 6.8.2).

6.8.1 Policy Rationale The policy rationale for having special short-term rules is

outlined in the following passage from the Explanatory Memorandum to the Bill which introduced the provisions:


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This exception recognises that a forex realisation gain or loss may be seen as incidental, or closely related, to a gain or loss arising in respect of another asset on capital account. Therefore, for tax purposes, the foreign currency gains and losses are treated as having the same character as the gains and losses on the asset to which the foreign currency right or obligation relates. This approach is sometimes referred to as ‘character matching’.

However, character matching treatment will only apply where the forex realisation gain or loss is short-term in nature. Broadly, such a gain or loss arises where the time between the time of acquisition or tax recognition time and the due date for payment for that asset is 12 months or less. A 24-month rule applies to the acquisition of depreciating assets - character matching payments that are due in the 12 months before the asset comes to be held as well as the subsequent 12 months.

These time limits are a statutory rule-of-thumb which attempts to distinguish between those rights and obligations to receive and pay foreign currency which are considered to be incidental to another transaction (eg the purchase and sale of a depreciating asset) and those which, in themselves, represent a separate financing arrangement.95

6.8.2 Specific Consequences of Making Short-term Forex Realisation Gains and Losses

The tables in s 775-70 and s 775-75 explain the specific consequences that flow where short-term forex realisation gains and losses arise. The main results are summarised below:

Short-term forex realisation gains • Where a taxpayer makes a forex realisation gain as a result

of FRE 2 and the right to receive foreign currency was created in return for the disposal of a CGT asset (other than a depreciating asset), the forex realisation gain is not included in assessable income under s 775-15. Instead,

95 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, paras 2.184-2.186.

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CGT event K10 occurs when the forex realisation event happens. This results in the taxpayer making a non-discountable capital gain equal to the amount of the forex realisation gain.

• Where a taxpayer makes a forex realisation gain as a result of FRE 4 and the obligation to pay foreign currency was incurred in return for the acquisition of a CGT asset (other than a depreciating asset), the forex realisation gain is not included in assessable income under s 775-15. Instead, the cost base and reduced cost base of the CGT asset is reduced by the amount of the forex realisation gain.

• Where a taxpayer makes a forex realisation gain as a result of FRE 4 and the obligation to pay foreign currency was incurred in return for acquiring a depreciating asset, the forex realisation gain is not included in assessable income under s 775-15. Instead, the asset’s cost, its adjustable value, or the opening value of the pool in which the asset resides is reduced by the forex realisation gain.96 If the forex realisation gain is greater than the asset’s cost, opening adjustable value, or the opening value of the pool, the excess is included in the taxpayer’s assessable income.

Short-term forex realisation losses • Where a taxpayer makes a forex realisation loss as a result

of FRE 2 and the right to receive foreign currency was created in return for the disposal of a CGT asset (other than a depreciating asset), the forex loss is not deductible under s 775-30. Instead, CGT event K11 occurs when the forex realisation event happens. This results in the taxpayer making a capital loss equal to the amount of the forex realisation loss.

• Where a taxpayer makes a forex realisation loss as a result of FRE 4 and the obligation to pay foreign currency was

96 But not below zero.


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incurred in return for the acquisition of a CGT asset (other than a depreciating asset), the forex realisation loss is not deductible under s 775-30. Instead, the cost base and reduced cost base of the CGT asset is increased by the amount of the forex realisation loss.

• Where a taxpayer makes a forex realisation loss as a result of FRE 4 and the obligation to pay foreign currency was incurred in return for acquiring a depreciating asset, the forex realisation loss is not deductible under s 775-30. Instead, the asset’s cost, its adjustable value, or the opening value of the pool in which the asset resides is increased by the amount of the forex realisation loss.

6.8.3 Election Not to Use the Short-term Rules

A taxpayer can make an irrevocable written choice under s 775-80 for the short-term rules not to operate.97 The effect of making such a choice is that the basic rules in s 775-15 and s 775-30 operate in respect of any forex realisation gains and losses instead of the special rules in s 775-70 and s 775-75.

6.9 Roll-over relief for facility agreements

Special roll-over relief is available under Subdiv 775-C to the issuer of “eligible securities” under a “facility agreement”. The circumstances in which this relief operates and the effect of the relief are discussed below (see 6.9.1 to 6.9.5).

6.9.1 Facility Agreements and Eligible Securities

A “facility agreement” is an agreement between an entity and one or more other entities under which the first entity has a right to issue “eligible securities” and the other entity or entities acquire those securities. The economic effect of the agreement must be such that it enables the first entity to obtain finance in a particular foreign

97 A choice to opt out of the short term rules must be made within the time periods specified in the section.

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currency up to the foreign currency amount specified in the agreement during the term of the agreement.98

“Eligible securities” are bills of exchange and promissory notes that are non-interest bearing, issued at a discount, denominated in a foreign currency, and are for a fixed term. They can also include securities specified in the regulations that are denominated in a foreign currency and are for a fixed term.99

6.9.2 Roll-over Choice

Roll-over relief is only available under Subdiv 775-C if the issuer of the eligible securities has made a choice100 seeking roll-over relief for a particular facility agreement.101

Furthermore, roll-over relief is only available if the issuer discharges an obligation to pay foreign currency under an eligible security and at the same time issues a new eligible security pursuant to the agreement.102 The issue of the new security must be related to the discharge of the issuer’s liability under the rolled over security in one of the following ways:

• the issuer’s obligation to discharge the liability under the rolled over security must be wholly or partly set-off against the issuer’s right to receive the foreign currency issue price of the new security; or

• the issuer’s obligation to discharge the liability under the rolled over security must be wholly or partly satisfied by the issue of the new security.

98 ITAA97, s 775-185. 99 ITAA97, s 775-190. 100 The choice must be made within 90 days of the first time the entity issues an eligible security under the facility, within 90 days of the “applicable commencement date” (as defined in s 775-155), or within 30 days of the commencement of the section (ie by 16 January 2004). The choice must be made in writing and is irrevocable. It operates from immediately before the first time a security is issued or the applicable commencement date and continues until the facility agreement ends. 101 ITAA97, s 775-195. 102 ITAA97, s 775-205.


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6.9.3 Consequence of Choice

There are two important consequences of making a choice under s 775-195:

1. The first consequence is that any forex realisation gain or forex realisation loss that would otherwise arise to the issuer as a result of FRE 4 (ie from the issuer discharging its obligations to pay foreign currency in relation to the rolled over eligible security) is disregarded.103

2. The second consequence is that the issuer is treated as having been provided with a “notional loan”.104 This recognises the fact that a facility agreement comprising a series of discounted instruments is often economically analogous to a continuous loan.105 The effect of the roll-over on the notional loan is based on the rules stated in the table in s 775-210(3) which depend upon how the foreign currency face value of the new security compares to that of the rolled over security. Broadly, and in simplistic terms, the table operates as follows:

• Where the face value of a new security is the same as that of the rolled over security, the notional loan is treated as having been extended.

• Where additional capital is raised under the facility (ie there is a new “draw-down”), a new notional loan is taken to arise for the increased amount.

• Where there is a reduction in the capital outstanding under the facility (ie the foreign currency face value of the rolled over security is less than the foreign currency value of the rolled-over security), the issuer is taken to have paid a foreign currency

103 ITAA97, s 775-200. 104 ITAA97, s 775-210(2). 105 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, para 2.251.

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amount in order to discharge its obligation. In this circumstance, forex realisation gains and losses may be triggered under FRE 6 (see 6.9.4).

6.9.4 Forex Realisation Event 6

FRE 6 happens where the issuer discharges its obligation, or part of its obligation, to pay the foreign currency principal amount of a notional loan attached to an eligible security issued under a facility agreement.106 The time of the event is when the obligation (or part thereof) is discharged.107

The rationale for having FRE 6 is that the roll-over relief under Subdiv 775-C is only designed to defer forex realisation gains and losses arising under a facility agreement while foreign currency amounts remain outstanding on the notional loans. To the extent that a notional loan has been discharged, it is necessary to determine the extent to which forex realisation gains and losses have arisen. FRE 6 is the mechanism used to calculate such gains and losses.

The circumstances in which the issuer makes a forex realisation gain or forex realisation loss under FRE 6 are as follows:

• Forex realisation gain. The issuer makes a forex realisation gain under FRE 6 if the amount of the obligation (or part thereof) at the start time of the notional loan exceeds the amount paid in order to discharge the obligation (or part thereof), and some or all of the excess is attributable to a currency exchange rate effect. The amount of the gain is so much of the excess as is attributable to the currency exchange rate effect.108

• Forex realisation loss. The issuer makes a forex realisation loss under FRE 6 if the amount of the liability (or part thereof) at the “start time” of the notional loan, falls short

106 ITAA97, s 775-215(1) 107 ITAA97, s 775-215(2). 108 ITAA97, s 775-215(3).


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of the amount paid in order to discharge it (or part thereof) and some or all of the excess is attributable to a currency exchange rate effect. The amount of the loss is so much of the shortfall as is attributable to the currency exchange rate effect.109

6.9.5 Forex Realisation Event 7

FRE 7 arises where there is a material variation to the terms or conditions or effect of a facility agreement or to the types of securities that can be issued under it.110 The time of the event is when the material variation happens.111

FRE 7 is designed to apply where the relevant facility agreement is no longer analogous to a continuous loan because its terms have changed. Where FRE 7 happens in relation to a facility agreement, the notional loan effectively ceases and forex realisation gains and losses can therefore potentially arise under FRE 4 every time an obligation to pay foreign currency in respect of the security is discharged under the facility.112

The circumstances in which an issuer makes a forex realisation gain or forex realisation loss under FRE 7 are as follows:

• Forex realisation gain. The issuer makes a foreign exchange gain under FRE 7 if (assuming it had discharged its liabilities under each notional loan arising under the facility agreement and not rolled-over any eligible security) the total forex realisation gains it would have made as a result of FRE 6 would have exceeded the total forex realisation losses it would have made as a result of FRE 6. The amount of the forex realisation gain is the excess.113

109 ITAA97, s 775-215(4). 110 ITAA97, s 775-220(1). 111 ITAA97, s 775-220(2). 112 ITAA97, s 775-220(6). 113 ITAA97, s 770-220(3).

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• Forex realisation loss. The issuer makes a foreign exchange loss under FRE 7 if (assuming it had discharged its liabilities under each notional loan arising under the facility agreement and not rolled over any eligible security) the total forex realisation losses it would have made as a result of FRE 6 would have exceeded the total forex realisation gains it would have made as a result of FRE 6. The amount of the forex realisation loss is the excess.114

6.10 Limited Balance Election for “Qualifying Forex Accounts”

A number of different forex realisation events can arise in relation to foreign currency denominated bank accounts. In particular:

• FRE 1 arises when an entity deposits foreign currency into such an account as the entity has disposed of foreign currency.

• FRE 2 arises when an entity withdraws foreign currency from such an account with a credit balance as the entity’s right to receive foreign currency from the bank cease to the extent of the withdrawal.

• FRE 4 arises when an entity deposits foreign currency into such an account with a debit balance as the entity’s obligations to pay foreign currency to the bank cease to the extent of the deposit.

To reduce the compliance costs associated with the general forex rules, taxpayers can elect under s 775-230 to have Subdiv 775-D apply to one or more “qualifying forex accounts”. In simple terms, where a taxpayer makes an election, forex realisation gains and forex realisation losses that arise as a result of FRE 2 or FRE 4 (but not

114 ITAA97, s 770-220(4).


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FRE 1) are disregarded if the account passes the “limited balance test” set out in the Subdivision.115

6.10.1 Qualifying Forex Account A “qualifying forex account” is a credit card account, or an

account held for the primary purpose of facilitating transactions, that is denominated in a foreign currency and is maintained in Australia with an ADI or in a foreign country with an ADI or similar institution. 116

6.10.2 The Limited Balance Test To pass the limited balance test, the combined credit and debit

balances117 of all the accounts covered by the taxpayer’s election must not be more than the foreign currency equivalent of A$250,000.118 This rule operates subject to a “buffer” provision, which allows the combined balance of the accounts to be no more than A$500,000 for up to no more than two 15-day periods in any income year.119

Where an entity breaches the limited balance test, FRE 2 and FRE 4 can apply to subsequent withdrawals from, and deposits to, the foreign currency denominated accounts. Forex realisation gains

115 ITAA97, s 775-250(1). Capital gains and losses that are attributable to currency fluctuations and which might otherwise arise pursuant to CGT event C1 or C2 are also disregarded: ITAA97, s 775-250(2). 116 ITAA97, s 995-1. 117 Debit balances are expressed as positive amounts (eg if a taxpayer owes US$10,000 on a credit card account, the debit balance of the account is US$10,000): ITAA97, s 775-245(5). 118 ITAA97, s 775-245(1). Compliance with the A$250,000 amount is determined by translating the amount into an equivalent amount of foreign currency in which the account is denominated using the average exchange rate for the third month that preceded the income year. The combined credit and debit balances in the relevant accounts are then measured against this translated amount: ITAA97, s 775-245(4). 119 ITAA97, s 775-245(2), (3).

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and losses that arise in these circumstances are calculated from the date of the breach.120

An entity can re-test after a breach and if it satisfies the limited balance test, the special treatment under the Subdivision will re-commence without the need for the entity making a fresh election. A notional realisation rule, however, applies in this situation to ensure that any gain or loss which accrued during the intervening breach period is brought to account on re-entry.121

6.11 Retranslation Election for “Qualifying Forex Accounts”

As an alternative form of relief to the limited balance exemption (see 6.10), an entity may make a choice under s 775-270 that the “retranslation rule” under Subdiv 775-E apply in relation to its qualifying forex accounts.

In essence, the retranslation rule allows an entity to account for the foreign currency gains and losses arising in respect of a qualifying forex account by simply restating the account balance annually by reference to deposits, withdrawals, and the relevant exchange rate at the beginning and end of the retranslation period (usually the income year).

6.11.1 Retranslation Choice

The choice under s 775-270 must be made in writing and continues until: (i) the entity ceases to hold the qualifying forex account, (ii) the account ceases to be a qualifying forex account, or (iii) the choice is withdrawn.

6.11.2 Consequences of Choice

There are two consequences of making a choice under s 775-270:

120 ITAA97, s 775-260. 121 ITAA97, s 775-255.


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1. The first consequence is that any forex realisation gain or forex realisation loss arising under FRE 2 or FRE 4 in respect of the qualifying forex account is disregarded.122

2. The second consequence is that FRE 8 applies for the relevant “retranslation period” (see 6.11.3). 123

6.11.3 Forex Realisation Event 8 Under FRE 8 it is necessary to apply the following formula,

contained in s 775-285(4), to determine the relevant “retranslation amount” (which may be either a positive or negative amount) for the “retranslation period”:

Closing balance of account for the retranslation period

-

Opening balance of account for the retranslation period

-

Total deposits made to account during the retranslation period

+

Total withdrawals made from account during the retranslation period.

The relevant exchange rates to be used in order to calculate the elements in the above formula are as follows: 124

• closing balance – the exchange rate at the end of the retranslation period;

• opening balance – the exchange rate at the beginning of the retranslation period;

• deposits – the exchange rate at the time the relevant deposit is made; and

122 ITAA97, s 775-280. Capital gains and losses that are attributable to currency fluctuations and which might otherwise arise pursuant to CGT event C1 or C2 are also disregarded: ITAA97, s 775-280(2). 123 ITAA97, s 775-285(1). 124 ITAA97, s 775-285(9).

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• withdrawals – the exchange rate at the time the relevant withdrawal is made.

The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 8 are outlined below:

• Forex realisation gain. An entity makes a forex realisation gain under FRE 8 if there is a positive retranslation amount for the account for the retranslation period. The amount of the forex realisation gain is the positive retranslation amount.125

• Forex realisation loss. An entity makes a forex realisation loss under FRE 8 if there is a negative retranslation amount for the account for the retranslation period. The amount of the forex realisation loss is the negative retranslation amount.126

7. CONCLUSION

Like most other forms of recent taxation legislation, the forex rules are based on provisions which are highly technical in nature, peppered with cross-references to other provisions within the statute, and riddled with lengthy tables and new forms of “jargon”. In this respect, the provisions can naturally appear quite daunting at first glance and certainly take some time getting used to. It is important to realise, however, that underpinning these complex rules are a set of relatively basic general principles.

One of the cornerstones upon which the forex regime is founded is the general translation rule. This rule generally requires each amount that is relevant to a tax calculation to be translated into A$ so that a constant unit of account is used to calculate a taxpayer’s tax liabilities for an income year. Subject to any special rules prescribed in the regulations, Parliament has chosen to use “spot” translation rules for this purpose as outlined in the table in s 960-50(6).

125 ITAA97, s 775-285(6). 126 ITAA97, s 775-285(7).


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The general translation rule, of course, does not apply where a functional currency choice has been made by an entity that keeps its accounts solely or principally in a foreign currency. In these circumstances, tax calculations can be made in the relevant foreign currency and the net amount for the year is simply translated into A$. This is a sensible and convenient exception to the general translation rule.

Another key principle that underscores the forex regime is that foreign currency exchange gains and losses are generally required to be brought to account on a “realisation basis” according to “event” based rules. This approach is similar to the style adopted under the CGT provisions and should, therefore, not appear all that unusual.

As with the currency translation rules, the general forex realisation gain and loss rules operate subject to various elections, such as those relating to facility agreements and qualifying forex accounts. These elections are also designed to overcome some of the practical problems and inconveniences that may otherwise be caused by the application of the general provisions and should, therefore, be viewed as a positive feature of the regime.

The new forex regime is, in effect, a comprehensive codified scheme for dealing with transactions relating to foreign currency and has been designed to replace the ad hoc set of rules for dealing with such transactions that existed in the past and that were scattered throughout the tax legislation. Leaving aside the limited number of exceptions to the regime (most importantly the exceptions relating to ADIs and non-ADI financial institutions), the new rules will now usually be relevant any time that transactions take place in foreign currency. Accordingly, they are of great importance to anyone practising in taxation.

australia’s new forex regime

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